Bloomberg reports that business restructuring, specifically global mergers and acquisitions (M&A) activity, reached $5.9 trillion in 2021, crushing the previous all-time high of $4.2 trillion set in 2015. In its article, Grant Thornton (GT) LLP said global M&A activity slowed in 2022 at a total value of $3.7 trillion, and most analysts are predicting that we could see a return to pre-2021 activity. However, a new GT LLP survey of M&A professionals found that, after a lengthy period of respite, M&A activity is expected to rebound in the second half of this year. In fact, the survey showed that 99% of respondents expect deal volume to increase over the next months, with 11% forecasting a significant increase.
What is business restructuring, and why do businesses restructure?
In the context of this article, business restructuring refers to the cross-border reorganization of commercial or financial relations between associated enterprises.
Business restructuring may often involve the centralization of intangibles, risks, or functions with the “profit potential” attached to them. As an example, consider the conversion of full-fledged distributors (that is, enterprises with a relatively higher level of functions and risks) into limited-risk distributors, marketers, sales agents, or commissionaires (that is, enterprises with a relatively lower level of functions and risks) for a foreign associated enterprise that may operate as a principal.
According to the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines, relationships with third parties (e.g., suppliers, subcontractors, customers) may be a reason for the restructuring. Some of the reasons reported by businesses for restructuring include the wish to maximize synergies and economies of scale, to streamline the management of business lines and to improve the efficiency of the supply chain, taking advantage of the development of web-based technologies that have facilitated the emergence of global organizations. Furthermore, business restructuring may be needed to preserve profitability or limit losses, e.g., in the event of an overcapacity situation or in a downturn economy.
How are tax authorities involved in business restructuring?
Multinational enterprises (MNEs) are free to organize their business operations as they see fit. Tax authorities cannot dictate how MNEs should design their structure or where they should locate their business operations. Business restructuring arrangements, though, may be motivated by the purpose of obtaining tax benefits. However, this does not in itself warrant a conclusion that it is a non-arm’s length arrangement.
Tax authorities, on the other hand, have the right to determine the tax consequences of the structure put in place by an MNE. This means that the pricing for restructured transactions should be determined according to the arm's length principle. The arm’s length principle requires that the prices charged for transactions between related parties be the same as those charged for similar transactions between unrelated parties. This is important because transfer pricing can have a significant impact on the tax liabilities of the related parties and the tax revenues of the countries in which they operate.
In view of business restructuring, the Bureau of Internal Revenue (BIR) in Revenue Audit Memorandum Order (RAMO) No. 1-2019 states that reduction of profits in a business restructuring is acceptable when the functions performed, assets employed, and risk assumed are actually transferred to an associate. It is viewed as commercially rational for a multinational group to restructure in order to obtain tax savings.
However, if, despite the reduction of profit, it is found that the local entity continues to perform the same functions and bears the same risks, the BIR will make the necessary adjustments. This is because, in an arm's length situation, an independent party will not restructure its business if it results negatively for it, where it has a realistic option available not to do so.
What are some transfer pricing considerations in a business restructuring?
1. Identifying the transactions that make up the business restructuring with precision.
There can be group-level business reasons for an MNE group to restructure. However, it is worth emphasizing that the arm’s length principle treats the members of an MNE group as separate entities rather than as inseparable parts of a single unified business. As a consequence, it is not sufficient from a transfer pricing perspective that a restructuring arrangement makes commercial sense for the group as a whole; it must be at arm’s length at the level of each individual taxpayer. Accordingly, there should be an accurate delineation of the transactions comprising the business restructuring and the functions, assets, and risks before and after the restructuring.
2. Reallocation of profit potential as a result of a business restructuring
When a change in business arrangements results in a reduction in profit potential or expected future profits, an independent enterprise does not necessarily receive compensation. The arm’s length principle does not require compensation for a mere decrease in the expectation of an entity’s future profits. When applying the arm’s length principle to business restructurings, it is important to determine whether there is a transfer of something of value (an asset or an ongoing concern) or a termination or substantial renegotiation of existing arrangements that warrant compensation between independent parties in comparable circumstances.
3. Indemnification of the restructured entity for the termination or substantial renegotiation of existing arrangements
The termination or renegotiation of contractual relationships in the context of a business restructuring might cause the restructured entity to suffer detriments such as restructuring costs (e.g., write-off of assets, termination of employment contracts), re-conversion costs (e.g., to adapt its existing operation to other customer needs), and/or a loss of profit potential. In these situations, it is important to evaluate whether, at arm’s length, indemnification should be paid to the restructured entity, and if so, how to determine such indemnification.
How can the MNE prepare for a possible transfer pricing audit?
As quoted by the famous Benjamin Franklin, “By failing to prepare, you are preparing to fail.” To ensure a high-quality transfer pricing risk assessment, MNE groups should structure themselves in a way that accurately reflects the economic substance of their transactions and operations to comply with transfer pricing rules. It is equally important to prepare transfer pricing documentation that provides useful information to the tax authority. Tax audit cases tend to be fact-intensive, so the availability of adequate information during the audit is critical.
Well-prepared documentation will give tax authorities some assurance that the taxpayer has analyzed the positions it reports on and has made a good faith effort to comply with the transfer pricing rules. The documentation should include an overview of the MNE group business, including the nature of its global business operations, overall transfer pricing policies, and global allocation of income and economic activity. Additionally, MNE groups are recommended to document their decisions and intentions regarding business restructurings, especially as regards their decisions to assume or transfer significant risks, before the relevant transactions occur. Taxpayers should be prepared to provide additional information and documentation to tax authorities upon request.
By carefully evaluating their compliance with transfer pricing rules and maintaining well-prepared documentation, taxpayers can help ensure that they are in compliance with applicable regulations and avoid potential penalties and other adverse consequences.
Let's Talk TP is an offshoot of Let’s Talk Tax, a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
As published in BusinessWorld, dated 31 October 2023
